Embracing Islamic Finance - Impact on Internal Audit

Embracing Islamic Finance Impact on Internal Audit Mohammad Faiz Azmi Leader of Islamic Finance practice, PricewaterhouseCoopers CS4 - 7 Agenda • •...
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Embracing Islamic Finance Impact on Internal Audit

Mohammad Faiz Azmi Leader of Islamic Finance practice, PricewaterhouseCoopers CS4 - 7

Agenda • • • • •

What is Islamic Finance Islamic Finance: where is it today Governance frameworks in Islamic Finance Key findings of PwC’s Shariah Audit Survey in Malaysia What should Internal Audit function be aware of going forward

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What is Islamic Finance

Slide 3

What is Islamic Finance Islamic Finance system Islamic Banking • Commercial • Investment/Corporate • Private banking • Venture capital • Wealth management

Islamic Capital Market • Sukuk issuance • Fund management/ collective investment scheme • Corporate advisory • Asset management

Islamic Asset Management • Liquidity management • Interbank placement

Takaful • Shariah compliance

• Family takaful • General takaful • Retakaful

• Product innovation • Risk management • Research & development

Islamic Financial System

Shariah scholars/ advisor Lawyers Auditors Traders

Professions Actuaries Risk managers

Journalist Accountants Fin. Analysts

Regulators Supervisors Researchers Slide 4

What is Islamic Finance Shariah-compliance financial activities

Financial transactions or activities

Financial transactions or activities which are Shariah-compliant

Slide 5

Slide 5

What is Islamic Finance Examples where conventional non financial institution companies may encounter Islamic Finance • Investor of Shariah compliant equities/ instruments • Issuer of Shariah compliant instruments (sukuk) • Obtain financing from Islamic financial institutions • Obtain Shariah compliant insurance products (takaful) from

Islamic financial institutions. Common Islamic Finance products: Islamic bond = sukuk Islamic insurance = takaful Islamic saving account = Wadiah Slide 6

What is Islamic Finance Features of Islamic Finance – a summary Sellers must own assets prior to sale

Genuine trade transactions

Tangible underlying assets/ enterprise forms the basis of most Islamic Finance transactions

Sharing of risks & rewards, eliminate short selling, future sales (only in exceptional situations) via Salam or Istisna contracts

Strong link between finance and actual economic activities whereby finance must be supported by economically productive activities and excessive debt leveraging is prohibited

Prohibitions on debt trading

Currency speculation

Higher level of disclosures

Trading in currencies is prohibited due to its speculative nature

Further need on transparency to provide comfort over Shariah-compliance and also other risks which are unique to Islamic Finance

Underlying assets

Islamic Finance encourages productive trade, but trading in debt is perceived as another form of ‘riba’

Slide 7

Slide 7

What is Islamic Finance Common Islamic Finance contracts • Murabahah (trade with mark-up

or cost-plus sale) • Salam (advance purchase) • Istisna (purchase order) • Ijarah & Ijarah Munthia

Bittamleek (leasing) • Mudharabah (profit-sharing, loss

borne by capital provider) • Musharakah & Diminishing

Musharakah (joint-venture)

Slide 8

Islamic Finance: where is it today

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Islamic Finance: where is it today Islamic Finance – key milestones Source: Khan (1996) and IDB (2005). PwC (2009)

AAOIFI and IFSB were established to address accounting and regulatory framework for Islamic Finance. Establishment of the first commercial Islamic bank, Dubai Islamic Bank.

Takaful (Islamic insurance) was introduced. Islamic Equity Funds were established.

Establishment of the first retail Islamic bank in Egypt.

A conventional bank opened a branch in Cairo for the construction of the Suez Canal, which caused a stir among Islamic scholars due to the Riba element.

Islamic economists offered the first description of interest-free banking.

Countries like Bahrain and Malaysia began to promote Islamic banking system within the conventional system

1890s

1950s – 1960s

1970s – 1980s

Establishment of Islamic Development Bank.

Dow Jones Islamic Index and FTSE Index of Shariah- compatible stocks were developed. Sukuk/Islamic bonds launched. London seeking to be Islamic Banking centre France, Ireland, Luxembourg and Switzerland have seen some interest in recent months

1990s to date Slide 10

Slide 10

Islamic Finance: where is it today Currently, the industry is experiencing its fourth wave 1st Wave Pioneers

[1975]

“Conventional institutions from the Far East, American and European Institutions moving into Islamic Finance” When leading conventional banks such as Citibank and HSBC started offering Islamic financing products – other leading conventional started to follow suit.

2nd Wave Muslim Government Led Institutions

•HSBC Bank Malaysia launched Islamic

structured investment-link plan (with takaful protection) to customers in 2008.

3rd Wave Commercial Islamic Financial Institutions from Muslim Countries

•Standard Charted Bank Pakistan

About 90% of HSBC’s corporate customers for its Islamic banking services are not Islamic companies

cooperate with Meezan Bank to provide Islamic USD based account to customers in 2011. •Senegal is looking to venture into the

[2011]

global sukuk market and Citibank is the arranger for Senegal’s first sovereign sukuk.

Slide 11

Slide 11

Islamic Finance: where is it today Islamic Finance spreading around the world Al Rajhi

ABN AMRO Bank

Credit Agricole

Abu Dhabi Islamic

UBS

RBS JP Morgan Chase

Citigroup DMI Group Bank Islam

Qatar Islamic

HSBC Holdings PLC

BNP Paribas

Al Baraka

Deutsche Bank AG Credit Suisse Group

ING Bank Dubai Islamic Barclays

Noor Dubai Slide 12

Slide 12

Islamic Finance: where is it today Even global top-10 banks (by asset) are into Islamic Finance Islamic Finance business?

Source: Fitch Ratings

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Slide 13

Islamic Finance: where is it today Recent global developments in Islamic Finance (1 of 3) Europe

France Abolished double stamp duty for Islamic mortgages Passed rules/regulation to support Islamic Finance activities In process of licensing Islamic banks Made fiscal & legal adjustment for IF transaction for IF transaction. i.e. taxation guidelines on sukuk & murabaha, , Ijarah and Istisnah United Kingdom Government sets and objective to entrench London as a global gateway for Islamic Finance Plans to issue sovereign sukuk, amend tax law on Islamic Finance Germany  Saxony-Anhalt state issued government sukuk  First Islamic bank to operate in 2010 Source: IFN

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Slide 14

Islamic Finance: where is it today Recent global developments in Islamic Finance (2 of 3) Africa

Senegal Plans to tap the growing Islamic Finance market by issuing its first sovereign Islamic Bond in 2011 South Africa In the process of introducing tax neutrality laws for Mudarabah, Murabaha and diminishing Musharaka. Ethiopia Plans to open Zemzem Back – the first Islamic bank Uganda Three Islamic banks have applied for license from Central bank The Central Bank of Uganda is amending its banking regulations to allow for establishment of Islamic Banks North Africa Full-fledged Islamic Banks are already established in Egypt, Algeria and Tunisia and Islamic windows in Egypt, Morocco and Algeria Source: IFN

Slide 15

Slide 15

Islamic Finance: where is it today Recent global developments in Islamic Finance (3 of 3) Asia

Japan Law passed allowing banks to conduct Islamic Finance Financial Service Agency of Japan (FSA) has proposed tax reforms on various Islamic Finance related issues in its proposal on tax reform for 2011 Hong Kong Plans include changes to or clarifications of taxation arrangements to promote the issuance of Sukuk. Hang Seng Islamic China Index fund in 2007 Singapore Established first Islamic bank Introduced tax neutrality for Islamic Finance Launched Islamic ETF Source: IFN

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Slide 16

Islamic Finance: where is it today Global Islamic Finance statistics • Total Shariah-compliant banking assets exceeded USD1 trillion in 2011. • Catering for a growing Muslim population of 2 billion worldwide by 2020. • In 2010, there are >400 Islamic financial institutions in more than 50 countries. • Market Capitalization of Dow Jones Islamic Index surpassed the USD20 trillion mark in 2009. Slide 17

Governance frameworks in Islamic Finance

Slide 18

Governance frameworks in Islamic Finance Background: three influential institutions in Islamic Finance globally 1. Central Bank of Malaysia (Bank Negara Malaysia, in short BNM)

2. Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

3. Islamic Financial Services Board (IFSB)

Slide 19

Governance frameworks in Islamic Finance BNM Chart: Shariah governance structure 2011 (1 of 2)

Slide 20

Governance frameworks in Islamic Finance Key points of Malaysia’s Shariah governance framework (2 of 2) 1. Comprehensiveness. The framework is comprehensive and provide guidance on Shariah audit, Shariah review, Shariah risk management and Shariah research function. 2. Shariah scholars. Strict requirements in terms of qualification and independence of Shariah scholars. 3. Number of Shariah Committee members. Minimum of 5 members are required. 4. Conflict resolution. Rules are in place to manage risks of conflict. 5. Enhanced role of Shariah Audit. Need to cover more than Shariah risks in products and services. Must look at framework, scholars’ decision process, risk management and other key infrastructure areas. Slide 21

Governance frameworks in Islamic Finance AAOIFI governance framework (1 of 2) To date, AAOIFI has issued seven governance standards covering: 1.Appointment and composition of Shariah Supervisory Board; 2.Checks and balances brought about through external Shariah reviews; 3.Functions of internal Shariah reviews; 4.Monitoring of Shariah-compliance by audit and governance committees; 5.Independence of Shariah Supervisory Board; 6.General statement on governance principles for IFIs. 7.Corporate social responsibility

Slide 22

Governance frameworks in Islamic Finance AAOIFI governance framework (2 of 2) In April 2011, AAOIFI released an exposure draft on “Professional Code of Conduct for Shariah Supervisory Board” Example of some key points in relation to Shariah scholars: • The number of other Shariah Supervisory Board that he or she is already serving • The time needed for the proposed scope of work for the Shariah Supervisory • • • •

Board Whether he or she is a full time scholar or hold an employment position. Years of experience in industry The strength of Shariah division of the IFI to give support to Shariah Supervisory Board and IFI’s framework Whether he or she is also serving on other non IFI organization and committees. Slide 23

Governance frameworks in Islamic Finance IFSB’s Guiding Principles on Corporate Governance for IFIs (1 of 2) Part 1: General governance approach of institutions offering Islamic financial services Institutions offering Islamic financial services shall: •have comprehensive governance policy framework. •ensure that reporting (financial and non-financial) meets international requirements & is Shariah compliant. Part 2: Rights of investment account holders •Investment account holders have the right to monitor the performance of their investments and understand the associated risks. •Institutions offering Islamic financial services shall adopt a sound investment strategy and align to the risk and return expectations of investors. Slide 24

Governance frameworks in Islamic Finance IFSB’s Guiding Principles on Corporate Governance for IFIs (2 of 2) Part 3: Compliance with Shariah rules and principles Institutions offering Islamic financial services shall: •have mechanism for obtaining rulings from Shariah scholars, applying fatwa and monitoring Shariah compliance. •comply with the Shariah rules and principles. Part 4: Transparency of financial reporting in respect of investment accounts Institutions offering Islamic financial services shall: •make adequate and timely disclosure to investment account holders and the public of material and relevant information.

Slide 25

Governance frameworks in Islamic Finance Key differences between Shariah and Conventional governance framework Conventional There is no Shariah Committee equivalent counterpart for conventional financial institutions.

Shariah •Scope of Shariah audit includes a review of the adequacy of Shariah governance process as well financial and management audit.



Scope of internal audit covers both financial and management audit.

•Risk management includes additional Shariah noncompliance risk.



Risk management process addressing credit, market, liquidity, operational, legal and other risk.

•Shariah Committee and the Board to have oversight on accountability on Shariah related matters.



Slide 26

Key findings of PwC’s Shariah Audit Survey in Malaysia

Slide 27

Key findings of PwC’s Shariah Audit Survey in Malaysia Introduction to PwC’s Shariah Audit Survey

• Surveys were sent on 12 November 2010, to over 15 financial institutions (both standalone and Islamic windows) in the country. • Survey questions organised into: People, Organisation, Working practices, Communication & Reporting and Technology. • 10 responses have been obtained and 5 key findings have been identified. • This was based on the pre-2011 Shariah governance framework. Slide 28

Key findings of PwC’s Shariah Audit Survey in Malaysia Key finding 1/5. Talent pool and competencies • Our Shariah audit staff are adequately trained in Shariahrelated audit risks and issues.

• Our Shariah audit staff are adequately trained in banking operations and financing products.

Need to expand talent pool with Shariah audit knowledge competencies. Slide 29

Slide 29

Key findings of PwC’s Shariah Audit Survey in Malaysia Key finding 2/5. Working practices • The scope of Shariah audits are • Which areas are covered in the scope comprehensive enough to cover all of the Shariah audit? the relevant processes in the bank.

The scope of Shariah audit needs to expand to cover all aspects of business operations. Slide 30

Slide 30

Key findings of PwC’s Shariah Audit Survey in Malaysia Key finding 3/5. Shariah audit methodology • What is the level of involvement of the Shariah scholars in the Shariah audit? • The Shariah audit methodology and tools are adequate to perform the audit.

Shariah scholars’ involvement in the Shariah audit process can be enhanced. Slide 31

Slide 31

Key findings of PwC’s Shariah Audit Survey in Malaysia Key finding 4/5. Dispute resolution process • Is there a dispute resolution process in the bank’s existing Shariah Governance Framework?

Not applicable 20%

Yes 30%

No 50%

For an effective Shariah Governance process, the Shariah dispute resolution process should be further clarified.

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Slide 32

Key findings of PwC’s Shariah Audit Survey in Malaysia Key finding 5/5. Technology • The bank's IT system are sufficient to provide Shariah auditors with all the necessary data and information to complete the audit.

IT systems can be improved to provide Shariah auditors with necessary information to perform the audit.

Strongly Disagree 0%

Disagree 20%

Not Applicable 10%

Strongly Agree 20%

Agree 50%

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Slide 33

What should Internal Audit function be aware of going forward

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What should Internal Audit function be aware of going forward (1 of 3) 1. What does your organisation do with respect to Islamic Finance?

• Financial institution

: Window or standalone entity : Fiduciary and operational risks

• Non-financial institution

: Investor/ borrower? Or provider of service? : Operational risk

Slide 35

What should Internal Audit function be aware of going forward (2 of 3) 2. Has your Audit approach identified additional Shariah risks? Operational • who confirms that practice is Shariah compliant • have the operations SOP been amended to recognise and mitigate risk • is there an event loss collection process • are Shariah risk mitigation process hardwired into the IT system • who gives assurance that the processes have been followed such that the business or product can be held out as Shariah Compliant Legal • capacity to enter into IF transaction confirmed • clear what is the final authority on what is Shariah compliant Reputational • marketing documents are correctly representing the product and services • staff are adequately trained Slide 36

What should Internal Audit function be aware of going forward (3 of 3) 3. How well trained or experienced is your Internal Audit function to cover these areas? • • •

Shariah knowledge Understand typical Shariah risks Able to understand and adequately challenge the line function

Slide 37

How PwC can help • Shariah audit methodology and framework Our team is qualified in terms of experience and specific Shariah-related skills to perform audit in the IFIs and Takaful operators. • Shariah risk management framework Our team has capacity and capability to advise on Shariahbased risk management framework of IFIs and Takaful operators to ensure that Shariah non-compliant risks are adequately managed.

• Shariah audit co-source and Shariah audit skills training As part of continuous professional development (CPD), we are keen to share and contribute to the competency of Shariah audit personnel/ team in the IFIs and Takaful operators. • Shariah audit Quality Assurance Review (QAR) Quality Assurance Review (QAR) is part of our services and can accommodate reviews of Internal Audit functions that are covering Shariah risk. Slide 38

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Slide 39

THANK THANK YOU YOU

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